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Life Cycle Cost

Byron A. Ellis

Abstract

Life cycle cost (LCC) is an important technique for evaluating the total cost of ownership
between mutually exclusive alternatives. Executive Order 13123 requires government agencies
to use life cycle cost analysis (LCCA) to minimize the government’s cost of ownership.
Unfortunately, many stakeholders do not understand the concept of cost and proceed to
minimize project acquisition (first) cost, rather than total project cost. However, over the life of
the project, facility management cost is often two to three times higher than acquisition costs.
Therefore, it is essential to design for minimum facility management cost.

Introduction

Designers, engineers and constructors are under pressure from owners to minimize total
project cost. Unfortunately, many owners do not understand the concept of total project cost. As
a result, they seek to minimize acquisition (first) cost. Economists Alchian and Allen (1977)
argued that the term “cost” should never be used by itself; they noted that it should always be
identified with “total,” “average,” or “marginal,” so stakeholders would not confuse one with the
other. Good project management minimizes total project cost, rather than acquisition cost. Total
project cost is the cost incurred throughout the life of the project. It is the life cycle cost (LCC)
or whole life costing of the project and it includes acquisition cost, facility management cost, and
disposal cost (El-Haram, Marenjak, & Horner, 2002).

The tendency to confuse acquisition cost with LCC is widespread. Acquisition cost is the
initial project cost. LCC cost is the entire process of project outlays, which extend beyond
acquisition costs. Failure to account for all project outlays often leads to the selection sub
optimal alternatives. Therefore, it is important for owners to establish a robust capital project
management (CPM) process, with strict guidelines for project evaluation and control, as well as a
knowledgeable capital project manager responsible for evaluating and selecting assets with the
lowest LCC. Hestermann notes that although purchase price and LCC define the overall financial
health of an organization, they are generally depicted on different financial documents, one on
the balance sheet on the other on the income statement. Thus, the relationship between them is
seldom understood, and often ignored in the search for profitability and efficiency.

Absence of a robust CPM process inhibits valuable stakeholders’ inputs into the
definition requirement phase and often leads to project fragmentation. Project fragmentation
occurs when different phases of a project are viewed as separate entities. When projects are
fragmented, stakeholders tend to focus only on their visible costs and underestimate direct,
indirect, and cumulative impacts of their actions. As a result, there is little or no incentive to
holistically apply the principles of LCC, because it is more rewarding for each group to minimize
the cost that they are responsible for without considering the impact of their actions on total
project cost. Thus, in the absence of a holistic framework for managing projects, LCC will
seldom be used effectively.

Section 401 of Executive Order 13123 requires government agencies to use life cycle
cost analysis (LCCA) in making investment decisions to lower the government’s cost and reduce

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energy and water consumption (Fuller, 2005). Many government decision-makers, however, are
not aware that law and Executive Order require the use of LCCA (EO 13123).

Total Project Cost

Total project cost is composed of total acquisition cost, total facility management
(operation and support) costs, and total disposal cost (CT = CA + CFM + CD). Jones (1994) and El-
Haram and Horner (2003) indicated that, over time, the major costs of a system are facility
management costs rather than acquisition cost. Therefore, they stressed the importance of
designing systems that minimize total project cost rather than acquisition cost. It is also
important to note that the ability to influence total project cost is highest in the acquisition phase
of a project and lowest in the facility management phase (Chasey & Schexneyder, 2000). Thus,
project cost minimization must be embedded in the acquisition phase, particularly during the
definition requirements process.

Acquisition Cost

Acquisition cost is the initial project cost (the capital cost); it is the outlays incurred
prior to putting the asset, or system, in service. Acquisition cost is a function of the project
definition requirements. The definition requirements, which also has been labeled requirement
engineering, front-end-analysis, logistics engineering, constructability, and so on, is where
designers, engineers, and constructors use optimum knowledge and experience in planning,
design, procurement, and field operations to achieve the project objectives (Chasey &
Schexneyder, 2000). This phase determines the reliability, maintainability, and the effectiveness
of the project and its components; 80% of an asset or system life cycle cost is “locked” in this
phase (Chao & Ishii, 2004). Therefore, it is important to have a good understanding of how
specified assets or systems will perform in the future. That is, failure modes and their effects of
potential alternatives (usually two or more) should be evaluated and discussed with stakeholders,
particularly facility management personnel, prior to asset specification. Pinto and Kharbada
(1996) indicated that ignoring the environment and stakeholders contributes to project failure.
Mearig, Coffee, and Morgan (1999) noted that choices that designers make determine initial and
future costs. For instance, choosing vinyl instead of wood siding, or concrete over asphalt paving
determines initial and subsequent facility management costs. Thus, failure to understand project
trade-offs can significantly affect future maintenance and replacement costs (Chao & Ishii,
2004).

Facility Management Costs

According to El-Haram and Horner (2003) facility management costs may be two to
three times higher than acquisition costs. Thus, there is a need design projects that minimizes
facility management costs. El-Haram and Horner noted that integrated logistics support (ILS),
which embodies a combination of techniques used in the defense, aviation and oil industries to
select effective maintenance techniques should be used in the project design stage to minimize
future facility management outlays. One of the ILS techniques is LCCA, which uses future
management outlays to forecast the cost of ownership of mutually exclusive alternatives.
However, future facility management outlays, particular for newly developed assets, are often
unknown. Additionally, facility management data is not readily available and many designers and
engineers lack facility management experiences to make realistic assumptions (Gransberg &
Douglas, 2005). Hockley (1998) argues for a bottom up approach to design reliability, whereby
designers know why things fail.

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Under LCCA, facility management (operation and maintenance) outlays are future
expenses; costs incurred after the project has been placed in service (Mearig, et al., 1999).
Therefore, it is essential to use robust assumptions when using LCCA to compare mutually
exclusive alternatives. Reliable LCCA is possible by using historical facility management costs
from similar projects or assets as proxy and experiences facility management personnel.
Furthermore, deterministic analysis, such as sensitivity and breakeven analyses can be used to
evaluate uncertainty and risk. Sensitivity analysis is a procedure to determine the sensitivity of
the outcome of an alternative to changes in its parameters. For instance, if a small change in a
parameter results in a large change in outcome, the outcome is sensitive to that parameter.
Breakeven analysis is the point where total project revenue (savings) is equal to the total cost of
the project.

It is important to note, however, that not all future cost categories may be relevant
(Mearig, et al., 1999). If two alternates incur the same costs, they can be documented as such and
not included in the LCC comparison.

Disposal Cost

Disposal cost or residual value is also a future cost and often difficult to estimate.
Disposal cost is the cost, or gain, of getting rid of assets after use. It may include the net
remaining worth, as well as the cost of transferring or destroying the assets. Often, however,
disposal cost of assets being compared is assumed to be zero. Nonetheless, it could be positive or
negative.

Asset Life

Asset life is the period over which the asset is fully depreciated; it is the useful economic
life of the asset, often determined by previous historical performance. Therefore, asset life is the
period in which the asset contributes directly or indirectly to the future cash flow of the
organization. Thus, the level of maintenance, energy usage, and other factors necessary to
maintain the usefulness of the asset influences asset life determination. The asset life may or may
not coincide with the LCCA study period; it is, however, essential to use the same study period
when comparing mutually exclusive alternates (Fuller & Peterson, 1995). Consequently,
estimated replacement cost should be included for the asset with the shorter life; often the base
cost, adjusted for inflation, is used as a proxy for future replacement cost. When the study period
is determined by expected asset life, FEMP rules in 10 CFR 436 require that the common service
period is that of the asset with the longest expected life. For projects subject to FEMP rules the
LCC period cannot exceed 25 years.

Cost Breakdown Structure

In order to conduct a LCCA it is necessary to create a structure that facilitates the


identification of project costs in each of the life cycle phases (El-Haram et al., 2002). El-
Haram et al. noted that the British Standard 5760, part 23, has a cost breakdown structure
(CBS) that identifies all relevant costs categories in all appropriate life cycle phases. The
life cycle cost breakdown structure has five levels: 1) project level, 2) phase level, 3)
category level, 4) element level, and 5) task level. The project level, level 1, has three
phases: acquisition, facility management, and disposal. The phase level, level 2, breaks
down each of the three phases into their respective cost categories. Acquisition costs are
all the costs required to implement the project; facility management costs are all the costs

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required for operating, maintaining, and supporting the project during its useful life; and
disposal costs are the anticipated costs at the end of the project (asset) useful life. The
category level, level 3, takes each category and subdivides it into its cost elements. For
instance, acquisition costs includes construction costs, which can be disaggregated into
site the costs of preparation, superstructure, substructure, building services, and so on.
Likewise facility management includes maintenance costs which can be broken down into
their elements, such as condition based maintenance, preventive maintenance cost (PM),
reactive maintenance (RM) cost, custodial cost, and so on; and operating costs can be
broken down into utility cost, custodial cost, insurance, rent, and so on. The element
level, level 4, takes the categories from level 3 and breaks them down into their own cost
elements. For example, the cost of constructing the superstructure can also be
disaggregated into the costs of the building frame, floors, roof, stairs, walls, windows,
doors, and other structure elements (El-Haram et al.). El-Haram et al. also noted that the
cost of facility management follows the same breakdown. For example, utility costs can
be broken down into the cost of electrical, natural gas, water, sewer, and so on. The task
level, level 5, is the total cost of all the resources required to complete a task; Figure 1,
depicts the resources needed to construct, maintain, and replace a window.

Trade offs

It is often assumed that high quality building or building equipment results in lower
future costs; that there is a trade off between acquisition and maintenance costs. Ashworth
(1996), however, argued that such a trade off is not a given. He noted that it is possible that
higher quality acquisitions may require higher maintenance costs in order to maintain its high
quality. Nonetheless, he agreed that in general good quality material and higher standard of
workmanship often leads to lower future costs. In order to exploit this trade off, designers,
engineers, project leaders, and managers must thoroughly understand how, when, and under what
conditions items in the design may fail (Hockley, 1998). Therefore, they should have in-depth
understanding of the design and how it will be used in service. Hockley argued that the potential
effects of use and abuse that the design will have should be well understood by designers and
managers. One way to achieve understanding of design outcomes is to evaluate the performance
of similar projects and to apply ILS techniques, such as failure modes and effect analysis
(FMEA), and reliability centered maintenance (RCM). Teng and Ho (1996) believe that FMEA,
which is a technique that identifies potential failure modes, the effects and criticality of these
failures, should include the activities of both design and operations. RCM is a systematic
approach for identifying the most cost effective maintenance regime for an asset (El-Haram &
Horner, 2003).

Life Cycle Cost

LCC is an economic method for evaluating assets that takes into consideration all costs
arising from owning, operating, maintaining, and disposing of the asset (Fuller & Peterson,
1995). It is the total discounted cost of acquiring, operating and maintaining, and disposing of an
asset over a fixed period of time (Mearig et al., 1999). LCCA is a useful aid for comparing
lifetime cost of mutually exclusive assets to determine which asset provides the best value per
dollars spent (Ashworth, 1996; Mearig et al., 1999; Robinson, 1996) and it should be performed
early in the design process. Ashworth, however, do not believe that previous LCC calculations
have produced reliable forecasts. He noted that estimated values might be quite different from
actual values and that attempting to estimate far in the future could lead to forecasting errors. El-
Haram & Horner (2002) indicated that due to unreliable data it is difficult to define exact costs

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for each expense category - acquisition, facility management, and disposal. Barringer and Weber
(1996) noted that LCC is not an exact science; outputs are only estimates, and estimates are not
accurate. Nonetheless, given robust and realistic assumptions, LCC is an important tool for
ranking cost of ownership between mutually exclusive alternatives. Realistic assumptions can be
obtained from evaluating the performance, over time, of similar assets, conducting literature
reviews, obtaining information from manufacturers, vendors, contractors, and using average
support and maintenance costs (Robinson, 1996). Moreover, ILS requires that vendors and
contractors identify the physical requirements for support of new assets or systems before the
owners approve the acquisition (Jones, 1994).

The time period (useful life) associated with LCCA must be well established and
historically accurate. Additionally, the associated discount rate should be used with care, since
there are differences between real and nominal discount rates. The former excludes inflation and
the latter includes inflation. Thus, when comparing alternatives in a given period, the same
discount rate must be used. Furthermore, the discount rate is likely to change from period to
period, and there are many discount rates. When using the real discount rate in present value
(PV) calculations, cost should be expressed in constant dollars (Mearig et al., 1999). Taxes and
depreciation allowances should be accounted for in LCC calculations, as well as any local value
effect. Generally, the straight-line method of depreciation is used. It is simple to use and it is
based on the principle that each period of the asset life should depreciate equally. The value
effect refers to the market differential response to one alternate versus another. For example,
rental for buildings with carpet flooring are higher than for vinyl flooring.

PV is represented as:

PV = Σt CF
t=1
(1 + k)t
where:
PV = present value
CF = cash flow
k = cost of capital
t = time, Yrs

Net Present Value Calculation

The net present value (NPV) is one methodology used to determine LCC; it is also used
for capital budgeting where projects with the highest NPV exhaust the firm’s fixed investment
funding (Branson, 1979). NPV is the present value of an investment future cash flow (CF) minus
the initial investment (I). For many LCCA, however, cash flows are often negatives (outflows).
Therefore, the smallest negative, which is the highest NPV, should be selected. The following
formula is used to calculate NPV:

NPV = Σt CF - I
t=1
(1 + k) t
where:
NPV = net present value
CF = cash flow
I = investment
k = cost of capital
t = time, Yrs.

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Robinson (1996) used Table 1 to demonstrate LCCA for vinyl tiles floor covering. He
noted that the initial installation cost was $37.00 per square meter. A diminishing rate of 25% per
annum was used for tax depreciation allowance with a balancing adjustment of $2.08 in the final
year. However, as indicated above, most LCC calculations use the simpler straight-line
depreciation.1 Robinson used average contract cost to determine recurring cleaning and
maintenance costs, which was $32 per square meter. Additionally, he made an allowance for
value effect of $10.00 per m2 per annum. Table 1 can be used in combination with Excel
spreadsheet to determine NPV.

Data Barriers

The principles of LCC have been demonstrated theoretically (El-Haram et al., 2002).
However, practical implementation has been difficult due to unreliable and limited data.
Additionally, financial complexities, such as interest rates, inflation rate, and tax rates also
inhibit implementation (El-Haram et al.). These barriers, however, are no insurmountable. For
instance, El-Haram et al. noted that a comprehensible, consistent and flexible framework for
collecting LCC would mitigate unreliable and inconsistent data. Thus, it is possible to develop
accurate acquisition cost and to use historical costs to predict facility management costs, as well
as disposal cost.

Managerial Barriers

Most managers identify the acquisition (capital) phase of a project as the total project
cost. As a result, they minimize what they perceive as total project cost, which is merely
acquisition cost. However, the acquisition phase, where requirements are defined, locks in the
asset, or system, future reliability and hence outlays. Thus, it is important to understand the
impact of the acquisition phase on total cost of ownership of the asset or system. Total cost of
ownership is also affected by the way assets are operated and maintained. For instance,
buildings, building equipment, and custodial services that are allowed to decay will result in a
different LCC profiles than well-maintained facilities assets (Ashworth, 1996). Thus, when the
extent of a project scope is not well understood, implementation results in disparate intra-
organizational goals that leads to the minimization of partial and not total project cost, such as,
minimizing acquisition cost without regards to the future effects on operation and maintenance
costs.

Conclusion

It is important to understand the concept of total project cost to prevent equating total
project cost with acquisition (capital) cost. Total project cost is all the forsaken options the
project incurs and those it forces others to incur. If the project specifies and installs floors that
are difficult to maintain, it will either result in increased custodial costs or aesthetic problems
that could affect employees’ productivity. Alchiam and Allen (1977) noted that costs, such as
aesthetic problems, are not always measured by expenditure of claims on marketable resources
by paying money. As a result, too often costs due to inappropriate design are not borne by the
design team and project managers; rather they are transferred to users, and operation and
maintenance personnel. Finally, poor design frustrates users, operation and maintenance
personnel, and is often difficult and costly to correct. Therefore, stakeholders should
meticulously review design proposal to ensure that the designers conducted and documented
appropriate ILS analysis.

1
See Barringer’s free LCC Excel file at http://www.barringer1.com/lcc.xls.

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Table 1

Life Cycle Cost Calculation for Vinyl flooring Material (Robinson, 1996)
Year
0 1 2 3 4 5 6 7 8 9 10 11
Capital costs
Initial cost ($) 37.00
Replacement cost ($)
Value effect
Reduced rental value ($) -10.00 -10.00 -10.00 -10.00 -10.00 -10.00 -10.00 -10.00 -10.00 -10.00
Recurring costs
Cleaning ($) -32.00 -32.00 -32.00 -32.00 -32.00 -32.00 -32.00 -32.00 -32.00 -32.00
Tax depreciation allowances
Initial installations
Written down value ($) 37.00 27.75 20.81 15.61 11.71 8.78 6.59 4.94 3.70 2.78 2.08
Balancing adjustment ($) -9.25 -6.94 -5.20 -3.90 -2.93 -2.20 -1.65 -1.23 -0.93 -0.69
Tax
Taxable income ($) -51.25 -48.94 -47.20 -45.90 -44.93 -44.20 -43.65 -43.23 -42.93 -44.78
Tax benefit ($) 18.45 17.62 16.99 16.52 16.17 15.91 15.71 15.56 15.45 16.12

Net cash flow ($) 37.00 -42.00 -23.55 -24.38 -25.01 -25.48 -25.83 -26.09 -26.29 -26.44 -26.55 16.12
Net present value -256.43

Notes: Taxable income = reduction in rental value less clean cost less depreciation = -$10.00 -
$32.00 - $9.25 = -$51.25 in year 1.
Net cash flow = reduced rental value less cleaning cost plus tax benefit = -$10.00 - $32.00 +
$18.45 = -$23.55 in year 2.
Tax benefit = $51.25 x 36% applied in the following year to reflect the lag in the payment of tax
= $18.45 in year 2.
Net present value = net cash flow discounted at 3.2% (5% after tax @ 35%).

Window

Construction Cost Cost of Maintenance &


Repair & Alteration

Material Cost
P.M. Maintenance Reactive Maintenance Repair & Alteration

Timber Windows

Direct Cost Indirect


Metal Windows Cost

Manpower Management
uPVC Windows

Materials & Spares Support


Manpower

Equipment Cost Penalty Cost


Equipment Cost (Unavailability)

Figure 1. El-Haram, Marenjak, & Horner (2002) Level 5-breakdown structure of the task level

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